The Japanese Yen is at a 40-year low. Has the market gone too far?

• Wide US-Japan interest rate differentials continue to dominate. Although the BOJ has raised rates, the gap with the Federal Reserve remains substantial, keeping carry trades attractive and speculative short-yen positioning elevated.

• Fiscal concerns are adding further pressure. Record government spending has renewed worries about Japan's long-term fiscal sustainability, weighing on investor confidence in the currency.

• Japan's macro fundamentals are becoming more supportive for another rate hike. Firmer inflation, resilient wage growth, improving business sentiment and stronger corporate pricing power all increase the likelihood of another BOJ rate hike in 2H2026.

• The US dollar could lose some momentum. Softer-than-expected US non-farm payroll data has reduced expectations for an immediate Federal Reserve rate hike, potentially narrowing the expected US-Japan interest rate differential in the near term.

• We see scope for a gradual yen recovery in 2H2026. A combination of another BOJ rate hike, possible currency intervention, improving fiscal discipline could provide meaningful support for the yen from its current depressed levels.

The Bank of Japan (BOJ) raised its policy rate by 25 basis points to 1.0% in June 2026, bringing interest rates to their highest level since 1995. In theory, higher interest rates should support a stronger currency. Instead, the opposite happened. The yen weakened to its lowest level against the US dollar since 1986, breaching JPY162/USD on both 30 June and 1 July 2026.

Why has the yen remained so weak despite the BOJ's tightening cycle?

The interest gap between US and Japan remains wide

Although a 1.0% policy rate is a historic milestone for modern Japan, it remains far below the US Federal Reserve's policy rate of 3.50%-3.75%. The BOJ's latest 25 basis point hike has only marginally narrowed this gap, leaving the yen as one of the world's cheapest funding currencies and allowing carry trades to remain highly attractive.

Equally important, markets have largely dismissed the significance of the June rate hike because it had been heavily telegraphed by BOJ Governor Kazuo Ueda weeks in advance. With the move fully priced in, the announcement delivered little hawkish surprise.

Investors also remain unconvinced that the BOJ will embark on an aggressive tightening cycle. The central bank continues to emphasise a cautious, data-dependent approach, reinforcing expectations that any further rate increases will be gradual.

Meanwhile, the Federal Reserve has become more hawkish. The June FOMC projections imply a year-end 2026 policy rate of 3.75%-4.00%, with roughly half of policymakers expecting at least one additional rate hike this year. This stance is supported by core PCE inflation, which accelerated to 3.4% YoY, its highest level since October 2023 and well above the Fed's 2% target.

As a result, rather than focusing on today's slightly narrower interest-rate differential, markets are increasingly pricing the possibility that the gap could widen again later this year. This explains why speculative short-yen positioning has climbed to near-record levels (Figure 1).

Figure 1: The speculative short-yen trade has become increasingly crowded, leaving the market vulnerable to a sharp short squeeze

Fiscal concerns continue to undermine confidence

Japan's fiscal outlook has also become another headwind for the currency. The government approved a record JPY122.3 trillion fiscal 2026 budget, around 6% larger than the previous year. It also introduced a JPY3.11 trillion supplementary budget to help households and businesses cope with surging energy prices following the Middle East energy shock.

While these measures support economic activity, they also reinforce concerns over Japan's already enormous public debt burden, one of the highest debt-to-GDP ratios among developed economies. For currency investors, persistent fiscal expansion raises questions about long-term debt sustainability and acts as a structural drag on the yen.

Can the yen still strengthen in 2H2026?

Despite the current weakness, we believe conditions are gradually becoming more supportive for a stronger yen during the second half of 2026.

Currency intervention remains a near-term possibility

Japanese authorities continue to signal their readiness to intervene should currency movements become excessive. Finance Minister Satsuki Katayama recently reiterated that the government stands prepared to respond if exchange-rate moves become disorderly. Earlier this year, Japan spent JPY11.73 trillion intervening in late April and early May, helping the yen strengthen from around 162 to near 156 against the US dollar.

More recently, the yen abruptly strengthened to around 161.1 on 2 July (Figure 2), a move widely suspected to be another round of official intervention, although Japanese authorities have not confirmed it. In recent months, Japan has shifted towards unannounced, "ambush" interventions to support the historically weak yen. Rather than relying on verbal warnings that give markets time to position themselves, the Ministry of Finance appears to be intervening without notice, catching speculators off guard and increasing the cost and risk of betting against the currency.

Figure 2: The yen strengthened sharply on 2 July 2026

While intervention alone is unlikely to reverse the yen's weakness over a sustained period, it can discourage speculative positioning and reinforce the government's determination to prevent excessive currency depreciation.

With net speculative short positions in the yen remaining extremely crowded at around 146,000 contracts, repeated interventions could trigger a rapid short squeeze, forcing traders to unwind bearish positions. Such positioning-driven moves can cause the yen to appreciate sharply over a short period, amplifying the impact of official intervention beyond the initial market operation.

Japan's macro backdrop is becoming more supportive for another BOJ rate hike

The case for another BOJ rate increase later this year has strengthened.

Although Governor Kazuo Ueda continues to emphasise a gradual and data-dependent policy approach, the June meeting reaffirmed the BOJ's willingness to continue raising rates while maintaining accommodative financial conditions. Deputy Governor Ryozo Himino also warned that inflation could overshoot the BOJ's 2% target, highlighting the risks of delaying policy normalisation for too long. Together, these remarks suggest growing support within the Policy Board for further tightening if economic conditions continue to improve.

Recent inflation data also points in that direction. While headline and core inflation remained below 2% in May due to government energy subsidies, Tokyo's core CPI — a leading indicator of nationwide inflation — accelerated to 1.6% YoY in June from 1.3% in May. Producer price inflation also accelerated to 6.3% YoY, increasing pressure on businesses to pass higher costs on to consumers. Corporate pricing behaviour reflects this trend. According to Teikoku Databank, food and beverage manufacturers plan to raise prices on 2,269 products in July, more than double the 1,078 products announced in June.

Importantly, higher inflation is occurring alongside resilient economic fundamentals. Tokyo's core-core inflation rose to 1.9% YoY in June, while real wages remained positive during the first four months of the year. This has been supported by Japan's annual wage negotiations, which delivered average pay increases of more than 5% for a third consecutive year. As a result, household purchasing power continues to outpace inflation, providing a solid foundation for domestic consumption.

Business confidence also remains robust. The BOJ's latest Tankan survey exceeded market expectations, with the headline diffusion index rising to +22 from +17, marking the strongest reading in eight years. Strong global demand for AI-related equipment and semiconductors has helped manufacturers offset higher input costs and supply disruptions stemming from the Middle East conflict. Meanwhile, the large non-manufacturing index improved to +37, supported by continued strength in inbound tourism.

The US outlook may become less supportive for the dollar in the near term

The US side of the equation has also become slightly more favourable for the yen in the near term.

June non-farm payrolls increased by only 57,000, well below market expectations of 110,000, while May's payroll gain was revised down sharply from 172,000 to 129,000. Following the report, market expectations for near-term Fed tightening eased noticeably. According to CME FedWatch, the probability of a July rate hike fell below 20%, while expectations for a September hike declined to around 50%.

One employment report is unlikely to fundamentally alter the Fed's hawkish stance, particularly with inflation still running well above target. However, softer labour-market data reduces the urgency for immediate policy tightening and gives the Fed more flexibility to assess incoming data before deciding whether additional hikes are necessary later this year.

This moderation in Fed tightening expectations, combined with increasing odds of another BOJ rate hike, could gradually narrow expected US-Japan interest-rate differentials — one of the most important drivers of the yen strength.

Japan is showing greater fiscal discipline

Concerns over Japan's fiscal outlook may also gradually ease. Although the government approved a JPY3.11 trillion supplementary budget, Prime Minister Sanae Takaichi's administration has explicitly committed to keeping total government bond issuance unchanged at approximately JPY183.8 trillion this fiscal year. Rather than issuing additional debt, the Ministry of Finance offset the new spending by cancelling previously authorised bond issuance.

At the same time, stronger corporate profits, rising wages and higher inflation have lifted tax revenues to a record JPY84.2 trillion for the fiscal year ended 31 March 2026, up 12% from the previous year. These stronger revenues are helping finance emergency spending without materially increasing net debt issuance.

This marks an important shift in fiscal policy. Instead of relying on debt-financed stimulus, Japan is increasingly funding supplementary spending through stronger nominal tax revenues while pursuing longer-term budget reforms aimed at reducing dependence on repeated supplementary budgets.

Although sustained fiscal discipline will take time to establish credibility, continued progress would help reduce sovereign risk premiums and gradually improve investor confidence in the yen.

Maintain a modestly positive bias on the yen

The yen remains under pressure as markets continue to focus on the wide US-Japan interest-rate differential and lingering fiscal concerns. While these headwinds have not disappeared, they are beginning to ease.

A more resilient Japanese economy, broadening inflationary pressures, rising probabilities of another BOJ rate hike, easing expectations for near-term Fed tightening, and improving fiscal discipline all point towards a more supportive backdrop for the currency.

Given how pessimistic market positioning, we believe the yen has meaningful scope to recover from its current excessively weak level of around JPY161 per US dollar during the second half of 2026. Hence, for investors looking to capture Japan's growth through fund investments, we favour an unhedged currency exposure. This allows investors to participate not only in the upside of Japanese equities but also in the potential appreciation of the yen as the currency gradually recovers.

Table 1: Recommended Products

Japan	·            Eastspring Investments - Japan Dynamic AS SGD ·            Amova Japan Equity SGD (formerly Nikko AM)
Japan Small Cap	·            Janus Henderson Horizon Japanese Smaller Companies A2 USD ·            BNP Paribas Japan Small Cap Classic Cap SGD

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.